Wednesday, April 2, 2008

Credit Writedowns

Bloomberg has a chart this morning tallying the credit write downs to date at major investment and commercial banks. The total so far is $232 billion. This is approximately half of the Goldman Sachs estimate of $460 of mortgage related losses, of which they estimate half will effect leverage financial institutions, and contribute directly to the process of deleveraging. This $230 billion that's going to get wiped out represents, according to the same paper, about 1/10th of the total banking system equity, and they estimate that this will create a cumulative US balance sheet contraction of around $2 trillion (after accounting for recapitalizations). This figure is again about a tenth of the assets held by leverage institutions in total. Please note that these estimates are not mark-to-market or anything remotely fictitious. They are based on estimates of how many people will default-- i.e. they are real economic losses.

What are the implications of all this? First, that we're only halfway through the writedowns in the banking sector. Bottom my left foot. Second, that 10% of the money in the US banking system just went up in smoke, and that's probably a conservative estimate.

But, well, in the immortal words of Tricky Dick Cheney, "So?" After all, a 10% reduction in equity hardly puts you on the doorstep of insolvency, so what exactly is the problem? Shouldn't this simply mean that bank stocks are worth 10% less, with a potential knock-on effect as they have to sell off 10% of their assets in order to maintain their leverage ratios? Perhaps the deleveraging effect (where reductions in equity are pro-cyclically accompanied by reductions in leverage ratio) makes this a little worse, but still, Citibank is not going out of business here. The biggest implication of the crisis may simply be that the US goes into a prolonged recession, as a comparison with the effect of past international banking crises suggests.

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